Abstract:
When open economies fix their exchange rate, they constrain monetary policy. The trilemma implies that arbitrage, not the central bank, determines how interest rates fluctuate. The annals of international finance thus provide quasi-natural experiments with which to measure how macroeconomic outcomes respond to policy rates. Using historical data since 1870, we estimate the local average treatment effect (LATE) of monetary policy interventions with a trilemma instrument and discuss the connection with the population ATE. Using local projection instrumental variable methods we find that the effects of monetary policy are much larger than previously estimated, and that these effects are state-dependent. Using a novel control function approach we allow for possible spillovers via other channels and our results prove to be robust. Monetary policy has weak effects when output is depressed and when the economy has “lowflation.” Our findings have profound implications for monetary economics.